Wednesday, March 27, 2013

Why Won't Cyprus Obey Krugman?

Longtime euro-critic, Paul Krugman tells Cyprus, "Leave the euro. Now." http://krugman.blogs.nytimes.com/2013/03/26/cyprus-seriously . He recognizes that it will probably not do so, but reasonably invoking the deep recession of neighboring Greece, he argues that they should leave before they end up like Greece. The question then arises, why are they not likely to do so, and for that matter, why has not Greece done so?

A lot of it of course is some sort of desire to "belong to Europe" and all that, which strongly influences both Greece and Cyprus, and continues to attract such possible joiners as Poland, which Krugman accurately notes did better than any other nation in Europe while not being in the euro during the Great Recession. Sweden also did well staying out, atlhough the UK is not such a great example. But, I think that there may be an economic fear that while probably overblown is not totally irrational. It is the fear of a possible major collapse in living standards from the likely massive devaluation that would arise if they were to get out (which as Krugman also notes, would not be all that easy to do).

The fact is that Cyprus is a very open economy, with imports running about 1/3 of GDP. A very major drop in the value of a new Cypriot currency would sharply increase the cost of living for Cypriots, and while the unemployment rate would certainly rise a lot, the entire citizenry would experience the potentially sharp decline in the standard of living. While this devaluation might make it easier for Cyprus to recover several years down the road, that recovery would indeed be several years down the road, and in the meantime there would be a lot of pain for the entire citizenry that will not happen if they stay with the euro.

The poster boy for this fear might be Argentina in 2001. The inflation rate went from actually negative just before the unpegging from the dollar to as high as 44% in 2002. The value of the peso fell to about 1/4 of what it was before, and while imports were only 22% of GDP, there was a massive short-term decline in living standards, with many middle class people at least temporarily thrown into poverty. That Cyprus would be moving off a long-in-place peg in a crisis environment suggests that it could experience a devaluation as bad as Argentina's or even worse.

OTOH, there is Iceland, a fave of Krugman's. Now they were floating, so not delinking from a longstanding peg. But in some ways they were arguably more vulnerable than Argentina or Cyprus, with imports running at 40-50% of GDP. After the 2008-09 financial collapse and banking crisis there, with many similarities to the Cyprus situation, their currency fell by more than half against both the dollar and the euro, but not by nearly as much as the Argentine peso fell. Inflation spiked from only around 2% to over 12% for two years in a row. They also had a recession, with the unemployment rate doubling, although that does not look all that much worse than what has happened in quite a few other European countries, and certainly not as bad as in Greece. But then, just as Argentina recovered after several years, so has Iceland's situation improved noticeably, although not all the way back to where it was before the crash.

Curiously, the more likely countries to see voters support an exit from the euro might well be some of the larger ones whose exit would be far more damaging to the euro itself (although some might disagree with that and say "good riddance"). The obvious case is Italy, where a majority of voters just supported candidates who at least criticized austerity policies imposed from outside, even if not necessarily supporting an exit from the euro (Grillo does, but Berlusconi has not so far). But such countries would probably not be hit as hard as Cyprus or Iceland or even Argentina for the simple reason that imports are smaller compared to GDP than in those smaller economies. A large devaluation, and it might not be as large anyway, would not impact the immediate cost of living as severely as happened in either Argentina or Iceland, or probably what would happen in either Greece or Cyprus.

19 comments:

The fundamental question is how elastic trade is to the exchange rate. Krugman assumes that exchange-rate elasticity is high, so that a devaluation will lead to a significant improvement in net exports in a reasonable amount of time. On the other hand, if you think the elasticities are low, a devaluation might not lead to higher net exports in the next few years, or ever.

That's the question -- not how big the devaluation would be, but how strongly it will affect trade flows.

Even with large elasticities, there is the J-curve effect. Exports do not increase immediately, whereas the value of imports tends to jump up immediately with their price increases.

As it is, Krugman is wrong about what they export. Their biggest one is refined oil products at about 21%. Tourism is big, but some low level manufacturing is much of the rest, not much ag. Some of these might have decent elasticities, although a potential danger is if they exit the euro they may also be forced to exit the EU and might even have trade barriers raised against them as punishment. This may also be part of the fear of the Cypriots about an unapproved exit from the euro.

The debate about devaluation versus the current path of deflation seems to rely largely on some combination of expectations and near-term risk aversion. If I understand Krugman correctly, the realistic options for Cyprus are either lower living standards through a quick, massive devaluation or lower living standards through slow internal deflation.

In either case the living standards decrease and Cypriots are less able to afford imports. Devaluation avoids the issue of sticky prices/wages that would lead to drawn out internal devaluation. It also open the possibility of export growth, depending on elasticity of trade (as JW mentions). If one presumes the fall in living standards is comparable, then the choice to exit the Eurozone and devalue appears to present larger potential benefits.

The current situation in Greece may be an appropriate example. GDP has fallen by ~30% and unemployment has more than doubled over the past 5 years yet a turnaround in either measure remains out of sight. If Greece had chosen devaluation in 2008-09, how much worse would the decline in output and rise in unemployment actually have been? Then, what are the odds the current state of unemployment and output would not only be better, but also improving?

Even with large elasticities, there is the J-curve effect. Exports do not increase immediately, whereas the value of imports tends to jump up immediately with their price increases.

Right. This makes the case for devaluation even weaker. It should be said, it depends a bit on what currency trade is priced in. But for Cyprus you are certainly right that even if the long-term elasticities are high enough for a devaluation to boost exports (which is far from certain) the short-run effect would certainly be to reduce, not increase, its foreign exchange earnings. It's a bit of a mystery why Krugman doesn't get this.

By and large I agree with most of Krugman's analysis. Clearly devaluation avoids the difficulty of internally adjusting. Quite likely not getting out will lead to a big increase in unemployment, as has happened in Greece.

JW,

I do not think that Krugman "does not get it." He is an expert on international econ above all things. He knows about J-curves and all that. But, it may be that he underestimates how sharp the devaluation might be, even though his major prof, Dornbusch was the great expositer of the exchange rate overshoot.

I think the real issue here has to do with time preferences. It may get down to hyperbolic discounting. People do not want to have pain in the near term. So, the fear by the whole population of near term pain in terms of standard of living may outweigh fear of a more gradual decline with rising unemployment, even though the shorter term sharp pain is likely to lead to a sooner turnaround to growth.

"It may get down to hyperbolic discounting. People do not want to have pain in the near term."

That's exactly what I was trying to get at it, though not in such concise language. If true, that type of discounting clearly works in favor of Germany and maintaining the Euro...assuming the costs aren't significantly higher in the long run.

Has anyone said anything about the theory of import replacement as a major component of the development of a society. This was a big thing of Jane Jacobs.

There are a lot of hollow societies out there. Sometimes they are resource rich, so they can export one thing in quantity, but have to import nearly everything else. Sometimes they are powerful, so they can export symbolic goods or military force and get everything else returned as tribute or booty.

Historically, cities and societies have developed by import replacement. The US, for example, placed a priority on indigenous manufacturing, and England's opposition to this was a major cause of the revolution. It doesn't always take a revolution to cut the necessary ties that prevent internal development. Sometimes it just takes a devaluation.

As is often the case, initial reserve estimates have ranged quite broadly, with the driller, Noble Energy stating -

''“991 billion cubic meters of natural gas have been discovered in Cyprus and Israel’s EEZ. The amount of natural gas discovered exceeds the needs of their domestic markets, which themselves will not be able to absorb the quantities of natural gas that will be produced. Its commercial exploitation is thus necessary through exports to other countries. ...''

While the GR Reporter [News from Greece] comments - ''the capacity of the region is around 85-255 billion m3 of natural gas. ...''

Very rudimentary look leads me to think URR will fall into the 350-500 m3 range which should certainly benefit such a small economy.

Natural Gas Europe reports ''the government expects and has relayed its views to the EU that by 2017-2018 full scale production should commence.''

Another well and they may be able to issue specially securitized bonds, but I wouldn't.

Aside from the above, looks as though Lebanon may have a relatively beneficial amt. of oil.

[Lebanon's deepwater area off its coast in the Eastern Mediterranean covers more than 7,600 square miles and offers a variety of unexplored hydrocarbon plays. However, while gas appears to be predominant in the southern part of the Levant Basin, offshore Israel, there is evidence to support the view that there might be plenty of oil resources in the waters of Israel's northern neighbor.]...Rigzone

Lebanese Geology Promises Offshore Oil Bonanza

http://www.rigzone.com/news/oil_gas/a/125280/Lebanese_Geology_Promises_Offshore_Oil_Bonanza========================Please pardon the crude nature of above but I think it belongs in the mix.

''With claims to what has been estimated to be worth $400 billion over the coming years, Cyprus has emerged as a new energy player in the Mediterranean over the past three years. Offering access to an estimated 50 to 60 tcf of gas and 1.7 billion barrels of crude in waters off its southeastern coast, Cyprus presented Europe with the kind of reserves that could finally ease dependence on Russia, not to mention meet and exceed domestic demand. Natural gas presented the surest way to rebound for a country with little else to rely on than a modest tourism sector and a bloated and unsustainable banking system.''http://www.forbes.com/sites/christophercoats/2013/03/28/where-does-the-cyprus-deal-leave-its-natural-gas/

"A very major drop in the value of a new Cypriot currency would sharply increase the cost of living for Cypriots, and while the unemployment rate would certainly rise a lot, the entire citizenry would experience the potentially sharp decline in the standard of living. While this devaluation might make it easier for Cyprus to recover several years down the road, that recovery would indeed be several years down the road, and in the meantime there would be a lot of pain for the entire citizenry that will not happen if they stay with the euro."

I need you to explain how staying with the euro will avoid a drop in standard of living. A devaluation would increase Cyprus's export earnings. Without earnings Cyprus cannot pay for imports. How will imports continue without earnings to pay for them? Or is the idea that without devaluation the drop in imports will be concentrated among the unemployed, enabling those who remain employed to maintain their current living standards? I need some clarification here.

Simple. A devaluation means that imported goods cost more, and Cypriots are highly dependent on imports for much of their consumer spending. The sharper the devaluation, the deeper the drop in their standard of living. The increase in exports will happen gradually.

I thank Juan for reminding us of the natural gas potential that Cyprus has. Apparently they were waving that at the Russians when their Fin Minister, Sarris, visited just before everything blew up, but for whatever reason, the Russians were not willing to help out, with their depositors in Cyprus taking the haircut instead.

OTOH, I note that the $400 billion might be overly optimistic, both because of some more recent reports that the pool may not be as big as originally estimated (or more of it is in Lebanese waters than Cypriot), and also because fracking in the US is driving the price of natural gas down, which will really matter if the US decides to export gas. But, there will be some increase in export earnings from natural gas for Cyprus, irrespective of whether they stick with the euro or bail.

It's worth noting regarding the gas that the Turkish Republic of Northern Cyprus has laid out its claim to the gas as well, which will reduce extraction as neither side will allow it to be extracted until the matter is settled.

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